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August 21, 2004
SEC and MLM
By QBlog in
I recently received an email from Gary L. Goodenow who is a former senior trial attorney for the enforcement division of the United States Securities & Exchange Commission. Here's an excerpt from that email:
I saw your web site on multi-level marketing (MLM). I am a former senior trial attorney for the enforcement division of the United States Securities & Exchange Commission. I was continually amazed at how little people know about what the SEC does — and does not do — to protect their investments. Among the areas I feel the SEC has failed miserably is that of MLM fraud. It largely ignores the problem, and all defense lawyers have to say to make an SEC investigation go away is "my client's program is just like Amway." Well, they're not, and many of them are scams that are now laundering dirty offshore drug money into clean MLM profits in the USA.
Goodenow (I love that name) invited me to republish an article he wrote for his Web site (RealityAtTheSEC.com) about the SEC and MLM. After reading the article I thought it was worth republishing here because it does help to clarify some confusion about MLM businesses.
The following article is solely authored by Gary Goodenow. I'm republishing it here with his expressed permission but the Creative Commons license on my site may or may not apply to Goodenow's article. If you'd like to republish this article, please contact Goodenow.
How can you tell the difference between an illegal pyramid, a Ponzi scheme and a multi-level marketing venture?
The difference between an illegal pyramid or Ponzi scheme and a legitimate multi-level marketing (“MLM”) program is never obvious, even to the most trained eye. Almost all of the present illegal Internet pyramid or Ponzi schemes are posing as legal MLM companies.
Pared to their essence, MLM programs akin to Amway survive legal scrutiny by making money off product sales, not new recruits to the programs. In contrast, “pyramid schemes” reward participants for inducing other people to join the program. No clear line separates illegal pyramid schemes from legitimate multi-level marketing programs. This lack of a red line is the gray area that fraudsters exploit to give their scams an image of legitimacy.
Very typically, in order to differentiate between an MLM and an illegal pyramid, securities laws regulators evaluate the marketing strategy of the issuer (e.g., emphasis on recruitment of new investors versus sales) and the percent of product sold compared with the percent of commissions granted.
The term “pyramid scheme”, as used by securities laws regulators, refers to a pyramid-structured program that chiefly exists to reward participants for inducing other people to join. Pyramids that can be considered MLMs are not ‘schemes’ at all, and are legal. All multi-levels are not considered per se deceptive and unlawful. So, it is possible that an Internet investment can have a pyramid structure and not run afoul of the SEC or Federal Trade Commission's (FTC) laws. But I don’t think it’s likely, nor is it likely that the typical investor, can really tell pyramid scams from legal MLMs on the Internet.
The term ‘Ponzi scheme’ typically means a program that pays earlier investors with money tendered by later investors. The original scheme by Carlo Ponzi in the 1920s was simple: investors paid him one dollar on the first day of the month, and he would commit to pay them two dollars on the last day of the month. To make that last day of the month payment, Ponzi used new investors money attracted to the program by the promised high returns. After Ponzi’s program failed, he went to work for Mussolini.
In the original Ponzi scheme, there was no recruitment down line and no commissions paid for recruiting investors to join below the founders. For this reason, securities law enforcement authorities, unlike the general public (and some courts), do not use the terms ‘pyramid scheme’ and ‘Ponzi scheme’ to mean the same thing. The difference is in the contractual relationship: all Ponzi’s investors had direct ‘privity,’ which means a contract connection, with his company, whereas a pyramid has privity down line between the members and recruits, and their recruits, on and on.
The legal differences in structure between a pyramid scheme and a Ponzi scheme are indistinguishable to investors: both schemes pay old investors with new investors money. But because there is technically a difference, fraudsters will huckster their program by declaring loud and clear: ‘this is not a Ponzi scheme.’ Sometimes they may even have legal opinions that state there is not Ponzi scheme, because: a) there is no SEC definition of a Ponzi scheme and b) the issuer’s program does not exactly replicate the terms and conditions of Ponzi’s 1920s program. So the disclaimer “This is not a Ponzi Scheme” is well nigh meaningless.
You see: a MLM pyramid is legal. Coupled with the nuances of legality arising out of regulatory decisions with respect to the famous Amway program, discussed below, it is confusing but true to state that a Ponzi scheme is not a pyramid scheme, and a pyramid may not be a scheme at all!
So how can I tell what I’m getting into?
With all due respect, you likely cannot tell the legal differences between Ponzi and pyramid scheme without great study. The FTC and SEC seek to enjoin both Ponzi and pyramid schemes on the basis that they will inevitably harm later investors. Very simply, the money has to come from somewhere, and when it stops coming, those who contributed last lose their investment. One Court held that these investments are “nothing more than an elaborate chain letter device in which individuals who pay a valuable consideration with the expectation of recouping it to some degree via recruitment are bound to be disappointed”.
The FTC, not the SEC, first went to Court to combat the “serious potential hazards of entrepreneurial chains” and urged the “summary exclusion of their inherently deceptive elements, without the time-consuming necessity to show occurrence of the very injury which justice should prevent.” In a leading decision, the FTC enjoined a promoter from “offering, operating, or participating in, any marketing or sales plan or program wherein a participant is given or promised compensation (1) for inducing other persons to become participants in the plan or program”. This FTC opinion had nothing to do with the federal securities laws. The holding was based on common law fraud concepts on the theory that such programs will inexorably fail because eventually there are not enough people on earth to support it.
The FTC test for determining what constitutes an illegal pyramid scheme holds that they “are characterized by the payment by participants of money to the company in return for which they receive the right to sell a product and the right to receive in return for recruitment, rewards which are unrelated to sale of the product to ultimate users”. The key concept is the ‘unrelated’ idea, that the program is so divorced from economic reality or mercantile endeavor, as to be merely a chain letter passing around money.
The FTC later recognized the distinction of “saturation” between legitimate pyramid structured programs and illegal pyramid schemes. In 1979, the FTC determined that the MLM program operated by Amway was neither fraudulent nor illegal. The FTC found that Amway is essentially structured as a pyramid, not a Ponzi scheme, with an ever increasing down line privity of recruits. Nonetheless, the FTC determined that the plan did not constitute an illegal pyramid because certain Amway rules ensured a focus on retailing merchandise over pyramiding of members. This effort at retailing, the FTC found, meant that the program would never be ‘saturated’ with members sending’ money to each other until there were no further people to join. It was these ‘anti-saturation’ rules that saved Amway’ from the ambit of the anti-Ponzi and pyramid scheme rules, not the specific structure of the enterprise. So, an Amway-like program that happened to pay participants a small fixed fee for bringing in recruits probably could constitute a ‘pyramid’, but such a program would not constitute a scheme to defraud because saturation will not occur.
How does the SEC get involved?
Securities regulators examine MLMs, pyramid schemes and Ponzi schemes for an investment contract, and therefore, securities, as defined by Section 2(1) of the Securities Act and Section 3(a)(10) of the Securities Exchange Act of 1934. The term “investment contract” is defined as (1) an investment of money; (2) in a common enterprise or venture; (3) premised on a reasonable expectation of profits and (4) to be derived from the entrepreneurial or managerial efforts of others. After the leading case on the subject, this is the famous Howey test.
An investment contract analysis considers each of these four factors:
- First Element - An Investment of Money
The term “investment of money” is where an investor commits assets to a venture in a way as to subject himself to financial losses. Under the usual investment vehicle, each investor commits funds to the capital development of a plan. Should a plan be unsuccessful, than the issuer will be unable to return an investor’s money. This is always the easy element to find.
- Second Element - Common Enterprise
The common enterprise element has been discussed in concepts known as ‘horizontal and vertical commonality’. Horizontal commonality requires the fortunes of each investor be linked to the others. Vertical commonality requires a finding that the fortunes of the investor are interwoven with and dependent upon the efforts of those seeking investments by new third parties. An investment plan is typically a common enterprise under both the horizontal and vertical common interest criteria. The fortunes of each investor are dependent upon the success of the issuer in either retailing merchandise in a legal MLM, or attracting new recruits in an illegal pyramid scheme, or attracting new investors’ money in a classic Ponzi scheme. Investors have a “vertical” common interest with the promoters of the plan, or third parties, and a “horizontal” common interest with other investors.
The concept of an investment contract does not require that the efforts of promoters or third parties be the sole efforts upon which the failure or success of the enterprise is based. Historically, there was some controversy on this point. The Supreme Court wrote of this prong of the test as “with profits to come solely from the efforts of others”. The present general rule virtually ignores the adverb “solely” in Howey and holds that investments where decisions made by those other than the investors are the essential, though not the exclusive, efforts effecting the failure or success of the enterprise.
- Third Element - Reasonable Expectation of Profits
The Supreme Court’s analysis under the Howey test of the term “profits” emphasizes the economic realities of the transaction, i.e., whether a purchaser is motivated by a desire to use or consume the item purchased or whether the investor is attracted solely by the prospects of a return on investment. Almost certainly in typical Internet investments, expectation of profit exists as the primary reason for the investment.
- Fourth Element - Solely from the Efforts of Others.
As discussed in element two on commonality, the concepts are intertwined. Courts today reject a literal application of the fourth element, “solely from the efforts of others.” One SEC enforcement action case held, in language that does not make any sense to some readers: “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” Yet his quotation expresses the general test under the fourth prong that is presently used by the SEC and state securities regulators in their enforcement actions against illegal pyramid and Ponzi schemes.
But what about my efforts to recruit others? How can you tell the difference between an illegal pyramid, a Ponzi scheme and a multi-level marketing venture?
In any investment, income is earned by raising money and then developing and retailing the good or service, until ultimately, profit is generated. Accordingly, returns are due to the results of efforts by persons other than the investor. MLM defenders often state that success is not due to the “efforts of others”, and so not a “security” because the member has to recruit others, and that takes work.
As to these “efforts” by the investor, there is one very critical distinction. Efforts to recruit new members to an MLM are not considered a bona fide “effort” to take the program out of the realm of an investment run by the “efforts of others ”. The regulators consider that recruitment effort is not what the normal investment contemplates. Why? Because they view it as closer to a meal recipe swap chain letter, then a real business. If the business is basically a system that sends money up the pyramid, it’s not a business at all.
Playing on the needs of MLMers to find new members, companies will sell them help. There are magazines for MLM marketing. For example, you can see for sale: “auto-pilot” advertising systems that work while you’re at the beach, “hot” prospect leads including 10,000 fax phone numbers, lists of other “networkers” in peel and stick label format and – of course- cash loans and “grants.” Here are some of the headlines:
“Explode Your Downtime On The Phone!”
“We Pay Every Monday!”
“Secret Bible Food Revealed.”
“Make Big Money And Help Others…”
“Join The #1 Team And Top $$ Earners…”
“Look Around… There’s Money Everywhere!”
“Make Hundreds, Even Thousands Of Dollars A Month, Every Month!”
“Ain’t Money Grand? How About A Few Extra Grand A Month?”
“Somebody Is Going To Get Paid…Why Not You?”
“Live In Your Dream Home Earning $900 To $3,600 A Day…”
And my personal favorite: “Make Money Like A Gangster.”
Observation: How many Internet investors can tell if an on line opportunity is a legal MLM or an illegal Ponzi or pyramid scheme pretending to be a legal MLM? Answer: few to none.
One person has come forward with a very serious analysis questioning the Amway case logic whereby it is not considered an illegal pyramid scheme. His comments deserve serious consideration, because of his experience and because of what appears at least to be, sincere motivation. Bruce A Craig, an assistant attorney general for the State of Wisconsin Department of Justice prosecuted a significant amount of pyramid schemes, in his 30 years of service. The list includes the Koscot Interplanetary case, which was the major original case in this area of the law. Mr. Craig wrote a letter to Robert Pitofsky, Chairman of the FTC, who was the person who drafted the original Amway opinion in 1979.
Mr. Craig wrote that since the Amway decision, “investments in pyramid type offerings have resulted in billions of dollars over the years”. I certainly agree with him there. He highlights that “the FTC Amway decision has created a good deal of uncertainty in respect to private and public legal efforts to deal with abuses of pyramid plans” that “will only increase with the onset of marketing over the Internet”.
Every time I prosecuted a pyramid or Ponzi or whatever, the first words out of the founder’s mouth were: “I set this up just like Amway”. Mr. Craig has called for the FTC to re-examine the aspects of Amway that make it legal because “the premise of ‘multi-level vs. pyramid’ may well represent a distinction without a difference”. I agree, as Mr. Craig is correct when he asks “whether these exculpatory factors can be effectively evaluated in time to prevent losses to the consuming public”. In my experience, the fraudsters know that, and that is why, unfortunately, when the SEC Enforcement Division comes in with an asset freeze, the money is long gone.
Comments
I agree with Mr. Craig. The FTC needs to re-examine the Amway situation.
It seems clear to me that Amway, at least as practiced by the various A/Q MO's, fails at least the third element of the "Howey test".
"Reasonable expectation of profit" is defined differently by the Howey test than it is by the courts which heard the various IRS fraud cases, but the result is the same.
The US Tax courts don't focus on the motivation, in fact they argue that the petitioners motivation in operating the 'business' must be given less weight than the facts of the case (ie - whether or not the tax payer 'believed' they would profit is less relevent that whether there was a 'reasonable expectation' based on the actual numbers).
The Howey test, "third element:...purchaser is motivated by a desire to use...the item purchased, or whether the investor is attracted solely by the prospects of a return on investment.", seems to imply that motivation is a key factor.
What percentage of Amway's sales is to end users with no 'expected return on investment', ie CUSTOMERS? I have read all the internet info I can get my hands on, and I can't find that particular piece if information (probably because no one, not even Amway, knows). I'd be surprised if it's 20%. Heck, I'd be surprised if it's TEN percent.
Sure, there's nothing wrong with "buying what you use anyway from yourself', but if you're paying twice what you would at the discount store, the question of motivation, as laid out in the "Howey test" seems pretty relevent. WHY?
Why are you paying twice as much? Is the product twice as good, and you'd buy it regardless of your expectation of profit? I haven't found too many Amway products that are ANY better than the brands I already buy. Many are worse. A few are genuinely better (SA8 stain remover has saved many garments in our home, some of which had already been treated many times with other leading brands).
So why pay twice as much? The motivation is nearly exclusiely "expectation of return on investment", in our home, and in the homes of most, if not all, of the IBOs I have known.
Amway has already failed, ad nauseum, the "reasonable expectation of profit" as defined by the US Tax court, and seems highly likely to fail the SEC's definition, as well. Perhaps that's why the number (what percentage of the dollars moved were to actual customers, whose motivation in purchasing is not 'return on investment', but 'desire to use the product') is not available. If Amway knew that number and somehow it got out, they'd be....ummm...screwed.
I think Amway has every right to conduct its business any way it sees fit. It is in the business of building consumership just like every other consumer-based business out there is.
If people are stupid and gullible, it's their own damned fault. And if people are criminally selling a scam and associating it with Amway, then the people are the criminals and if Amway doesn't find it within their priorities to clear their own name, then that's their own perrogative. They don't have to set ragulations on how people market their products just because you were too stupid to sell rather than buy. It's not their problem, it's yours, and this imbicilic idea that every time you screw up, all you have to do is blame somebody else and they should have to listen to your demands is exactly that.
You people are like a bunch of children, and it would do the Welfare budget and the taxpayers that are forced to pay into that budget a world of good if you'd just lay down and die.
Amway hasn't failed in anything. Do us all a favor and go play in traffic. Your whining is a tremendous waste of our O-zone.
Hmmm....since I'm the only one who replied with comments, I guess "you people" is referring to me.
I guess you missed the point of my post, Dwighty.
I'm not whining because anybody was 'forced' into buying anything. My POINT in reiterating the motivation for ourchasing was to illustrate that the motivation for purchase (expectation of profit) fails the SEC's test for a legal pyramid.
Do you get that? Are you following the difference between "Wahhhh...I'm broke and it's Amway's fault", and "Amway is, by the SEC's definition, an illegal pyramid"?
I have to assume that you understand my point, and therefor am anxiously awaiting a rebuttal to the FACTS. Another attack of the meesenger will either confirm my opinion that there aren't sufficient facts with which to pose a sufficient rebuttal, or that you are failing to grasp the difference between "whining" and pointing out the potential or real illegalities.
CK,
You quit, you are therefore, by default, a whining loser. Don't tell the truth CK, that makes you a whiner.
Dwighty, Amway HAS failed their distributors simply by doing nothing about the misrepresentaion, and perversion of facts that takes place whenever their sales and marketing plan is shown. The ONLY ones who could have stopped it chose not to is Amway.
It's fine if you wish to dissassociate Amway from BSM's, but one doesn't exist without the other. Amway was the host for the parasite, and did not pick off the bloodsuckers in order to protect the masses, and the blame for that lies solely with Amway.
I don't see Amway stepping up and taking responsibility for where things are at now. Here's the thing Dwighty; Who else could have stopped what has happened? Nobody but Amway. The only reaction that the diamonds have had to their tools abuses is people quitting.
The reaction should have come from the Amway corporation.
I'm not a welfare recipient, by the way, and I'm sure I pay more taxes then you, so perhaps think through your glib comments prior to posting them, because it is you that sounds like a spoiled child.
For the record, I am not now, nor have I EVER BEEN an Amway/Quixtar distributor. NEVER. No way, Jose, hit the road Jack.
Just wanted to make that clear. :)
i am a single 18 year old male. high school educated but also about 3 years away from retireing. i have been in the business for 18 months and my best month is business was 8,000 dollars. so no it is not quixtar that fails, it is the person. Do you have any idea how hard i work at this? no because u probably never had the commitment. me personally, i want the best i can offer for my future family. i don't want to have to leave my kids and wife at home while i go and work for someone elses dream. so all u people who say well i was in for this many years and didn't make a penny. it wasn't quixtar buddy it was you. o yea by the way i have a 10,000 dollar bonus coming in the next 5 months. yea what a scam this is huh. People corporations are 100x's more of a pyramid than this. think about it... you have ur president then under him ur v.p's and then ur supervisors and the the worker ants. all this is people is sharing an oppurtunity. it is also different and people hate whats different. i will admit i have worked my ass off i mean really worked but it is all worth it people it really is. and my friends who thouht i was tryin to get their money, now thank me every day for their solid income. im 18 years old people and a C student. but i swore to myself that no one was gonna hold me back from what i want out of life. so u read this and say oh hes corny u just remember somthing. when u walk into ur job on monday morning remember this IM NOT! Dame the lake is nice on them monday afternoons while ur at ur job.
Simply wow.
Posted by: Clifford Phillips | August 22, 2004 7:41 AM